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Climbing the Ladder

The Thornburg Limited-Term Municipal Fund is at the top of its category for nearly every time period imaginable. Co-manager Chris Ryon tells Barron's how the fund wins by "laddering" its portfolio over 10 years.

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If you can count to 10, you can understand the bond strategy that has put the $6.3 billion
Thornburg Limited-Term Municipal
Fund (ticker: LTMFX) at the top of its category over nearly every time period imaginable. But as with any experts, the strategy they appear to make easy is actually much more complicated than it seems.

Co-managers Chris Ryon, Josh Gonze, and Christopher Ihlefeld build a "laddered" portfolio, in which they spread the fund's assets across municipal bonds that mature every year for the next 10 years. It's a timeworn approach used by many advisors and individuals: The diversification inherent in laddering allows investors to minimize the interest-rate risk inherent in longer-term bonds and increase liquidity. As one year's worth of bonds comes to maturity, the money is redeployed into buying (in this fund's case) new undervalued bonds wherever they can be found along the one- to 10-year curve. As a result, the fund has a slightly longer duration than its peers, which has caused it to falter in times of rising interest rates. But there are other benefits that mitigate the brief periods of underperformance.

"The ladder minimizes trading, which minimizes capital gains and transaction costs," Ryon says, adding that the portfolio's turnover is 12.7%, compared with a category average of 39%. "It adds 20 to 30 basis points [or 0.2% to 0.3%] of incremental return, annually."

Other funds tend to stick to one part of the yield curve, investing in bonds that mature in the short-term (less than five years), or just bonds with 10- or 30-year maturities. But the laddering approach works just as well within a mutual fund, says Seth Fierston, with Fierston Financial Group in West Hartford, Conn., who has $43.5 million in the Thornburg fund. "We used to do it ourselves," he says, but now, as the municipal-bond landscape has become more complicated, "we use funds."

The fund's impressive long-term performance was at the hands of George Strickland, who ran the fund for 13 years, beating more than 90% of his peers in that time. Strickland moved to Thornburg's taxable-bond team nearly two years ago, but the new team—including Ryon, who came to Thornburg in 2008, after two decades managing municipal-bond funds at Vanguard—is executing the same strategy with the same success. The fund is up 3.8% in the past year, beating 89% of the 147 other municipal-bond funds in the category, whose return averaged just 2.2% in the past year.

"Thornburg runs a lean operation—Strickland sits just a few feet away," says Morningstar analyst David Falkof. "Josh [Gonze] is still doing the credit research and Chris Ihlefeld is still concentrating on trading. The team approach is the same."

The fund yields 2.02%, equivalent to 3.1% for an investor in the 35% tax bracket. (And the fund is sensitive to tax issues—it won't invest in any security that would incur the alternative minimum tax.) It carries a 1.5% upfront sales charge and a 0.72% expense ratio, which Morningstar calls below average.

LADDERING, OF COURSE, is simply the framework for the fund. Security selection is still key, Ryon says, and it's getting tougher. "The financial statements of most municipal issuers have become extraordinarily complex," says the native New Yorker, 56. "We want to see the quarterly financial statements to see how levered the issuer's balance sheet is, its cash position relative to debt, its operating margins, and how well it is able to pay its debt from its tax revenue."

Thornburg Limited-Term Municipal Fund

505-984-0200

Total Returns*

1-Yr

3-Yr

5-Yr

LTMFX

3.81%

4.20%

4.56%

Morningstar Muni

2.19%

2.23%

2.71%

% of

Top 10 Holdings

Ticker

Portfolio**

Texas St trans

8827225G2

2.0%

California St GO

13063BB68

1.8

N Y St Dorm Autho St P

64990EDA2

1.3

Chicago IL Sales Tax Rev

16768THJ6

1.1

Indiana St Fin Auth Rev

455057TP4

0.8

Okla St Dev Fin Auth

678908H80

0.8

Louisville + Jefferson Cntry KY

546589RY0

0.8

Denver CO City + Cntry Cops

249183UD4

0.8

N Y City NY Muni Wtr Fin

64972FWL6

0.7

Geisinger PA Authority

368497HA4

0.6

Total:

9.9%

*All returns are as of 12/13; three- and five-year returns are annualized. ** as of 11/30/12. Sources: Morningstar; company reports

Ryon's focus is on quantitative analysis. He compares each security with similarly rated bonds and evaluates whether there's any value to be found—say, a bond that offers a little extra yield for similar or not much more risk. The fund picked up many below-investment-grade bonds in 2008, 2009, and 2010 when they became very attractively priced because investors were so afraid of taking on any risk.

The rising prices of those low-quality bonds—such as a passel of BBB-rated Tennessee Energy Acquisition Corporation Gas Revenue Series C, which have increased 12.8%—have helped the fund climb 9.8% since August 2007.

All munis—not just the lower-rated bonds—have run up recently, Ryon says, and it's harder to find value. Real yields (the yield after inflation) on many bonds are now negative for much of the yield curve—you won't see a positive real yield until 10 years out. And the yield curve has flattened dramatically; longer-term bonds are not yielding as much more than shorter-term bonds as is typical. At the end of 2010, the average muni with a five-year maturity was about 130 basis points (1.3%) more than a one-year muni. Today, that spread has shrunk to just 54 basis points (0.54%). That means investors on the longer end of the curve are taking on more risk, Ryon says—interest rates would have to rise a mere 0.15% in one year to wipe out that extra income from a five-year bond.

Because of the spread compression, the pickings are slim, and the fund has more than 9% of its assets in cash, up from nearly zero 18 months ago, Ryon says. He's also moving more toward higher-rated bonds, like the AA-rated general-obligation bonds issued by the city and county of Honolulu, Series 2012B, and the A-rated Dormitory Authority of the State of New York School Districts Revenue Bond Financing Program Series 2012H, which all carry a 5% coupon, sell above par, and currently yield between 1.21% and 2.19%. "The yield may be low, but their relative value is attractive," he says.

Another favorite: the AA-rated State of Rhode Island and Providence Plantations General Obligation Bonds Consolidated Capital Development Loan of 2012, Series B, which have a 4% coupon, sell above par, and currently yield between 1.73% and 2.19%.

This fund's interest-rate sensitivity and value-orientation should help it stay at the top of the ladder.